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Derivatives under IAS-39: A Bird Eye view
The word Derivative in common parlance means anything which has no identity or value of its own. Its value is based on the movement in value of another. In the context of financial instruments the term Derivative indicates an instrument which is contractually settled based on certain external factors such as a price or interest rate movement etc. Thus a derivative does not exist devoid of the main instrument or contract. This article comments on the accounting logic under IAS-39 (Financial Instruments: Measurement and Recognition) rather than the basics of Derivatives or their definition contained therein.
A Derivative contract is generally short-lived for say 3 months or 6months etc. The Indian GAAP with its completely revamped standards (converged to IFRS) proposes to clearly demarcate a short term item from a long term one. Derivatives are to be accounted on ‘Fair Value’ basis as per IAS-39. Fair value prescription is laid wherever a short term is associated. By the way, short term attribute arises when realization of the instrument happens within the entity’s normal operating cycle. For e.g. a Forward contract in respect of an import of raw materials where the invoice is payable after 1 year and also assuming that the seller realizes cash from his customer only after 1 year, it means that his operating cycle extends beyond 1 year. In this context the trade payable is still a short term item though it crosses the one year mark. Applying this logic, an associated derivative (i.e. Forward contract) also becomes a short term balance sheet item. If an item is held on a short term basis the investor will be interested of its realization value at any item. Hence there exists a rationale behind Fair value basis which is nothing but the current market value in an arm’s length transaction.
The following is a Bird eye view on Derivative from the perspective of IAS-39,
Held for Speculation
No categorization
Fair value changes to P/L
Embedded in a Host Contract
Separable  (Not closely related)
Fair value changes to P/L
Non Separable (Closely related)
Accounting as per Host contract nature i.e. not as Derivative under IAS-39
Held as Hedging Instrument
For Fair value Hedge
Fair value changes to P/L
For Cash Flow Hedge
Fair value changes are held as a component of Equity
Navigating by the definition, Derivatives initially do not possess any value and hence at initial recognition their value is Zero, butlater their value gets recognized with every increase or decrease in the value of the underlying asset. Holding intentions carry immense significance in the new accounting regime.
Change in Fair value for e.g. in case of a currency futures contract means the increase or decrease in daily forward rates quoted in the market and not the spot rates. On the settlement date the forward rate converges to spot rate.
When Derivative is held for speculative purpose i.e. to book short term profits the initial and subsequent measurement will be on Fair value basis.
Sometimes it so happens that the value of a contract will be fixed as a constant amount plus a variable portion which will crystallize based on a certain external factor. A simple example is a contract for supply of goods wherein the price is fixed as say Rs.100000/- plus cash for every increase in the market value of the contractee’s own 100 shares up to a fixed date. In this case there is hidden (embedded) derivative in the form of a contract portion which derives its value based on the price difference of the shares. Thus if the current price of the shares is Rs.100/- and on the decider day the price increases to Rs.200/- the contract value increments by Rs.10000/- i.e. (200-100)*100. The standard mandates recognition of this portion of contract as Derivative. Of course the exception is where the derivative cannot be separately identified, in which case no separate accounting is required under IAS-39. These cases are called ‘Closely related Embedded Derivative’. A classic example given in the standard is a lease contract where the lease rental is based on the movement in the inflation index. Here the principal element of the contract being the lease rental is itself linked to an index movement; hence there is no separate derivative contract from the host contract. In fact the entire contract becomes a derivative!
The third classification is that of a derivative held for hedging i.e. to eliminate certain risks which could be unfavorable movement in the fair value of an instrument (Hedged item) or future cash flow. The standard christens two types of hedges namely Fair value hedge and a Cash Flow Hedge. The below table might make things clear,
Since the fair value change in the Hedged item has to be routed through P/L, the corresponding Fair value change in derivative is also to be taken to P/L; otherwise the purpose is of stabilizing the P/L is not served.
This hedge is meant to offset risk of increased cash flow at the time of settlement of an instrument. The hedged item may or may not be the one to be accounted on Fair value basis under IAS-39. Hence the standard requires parking the fair value change of this derivative as a separate component of equity only to be flushed out to P/L on final settlement. Until then P/L statement is insulated.
A Derivative to be accounted as Hedge requires proof of effectiveness i.e. how effectively it can mitigate the fair value change risk or cash flow. Currently a hedge is said to be effective if the risk is reduced to the range of 80-125% of the expected exposure. Hedge accounting also demands extensive documentation which will scare away many at inception.

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(IFRS Consultant)
Category Accounts   Report

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